Mortgages as Options
An option contract provides the contract holder the option to force the contract writer to either buy or sell a particular asset at a given price. A typical option contract has an expiration date, and if the contract holder does not exercise their contract rights by a given date, they lose their contractual right to do so. An option giving the holder the right to buy is a “call” option, and the option giving the holder the right to sell is a “put” option. The writer of an options contract is typically paid a fee or a premium for taking on the risk that prices may move against their position and the contract holder may exercise their right. The holder of an options contract willingly pays this premium to limit their losses to the premium paid if the investment does not go as planned. Most options expire worthless.
Mortgages took on the characteristics of options contracts in the Great Housing Bubble. Speculators utilized 100% financing and Option ARMs with low teaser rates to minimize the acquisition and holding costs of a particular property. The small amount they were paying was the “call premium” they were providing the lender. If prices went up, the speculator got to keep all the gains from appreciation, and if prices went down, the speculator could simply walk away from the mortgage and only lose the cost of the payments made, particularly when this debt was a non-recourse, purchase-money mortgage. Another method speculators and homeowners alike used was the “put” option refinance. Late in the bubble when prices were near their peak, many homeowners refinanced their properties and took out 100% of the equity in their homes. In the process, they were buying a “put” from the lender: if prices went down (which they did,) they already had the sales proceeds as if they had actually sold the property at the peak; if prices went up, they got to keep those profits as well. The only price for this “put” option was the small increase in monthly payments they had to make on the large sum they refinanced. If fact, on a relative cost basis, the premium charged to these speculators and homeowners was a small fraction of the premiums similar options cost on stocks. Of course, mortgages are not option contracts, and lenders did not view themselves as selling option premiums to profit from the premium payments; however, speculators certainly did view mortgages in this manner and treated them accordingly.
Today’s featured property exercised her “put” option she obtained from her lender in December 2006 with a “strike price” of $645,000. This was a far better deal than selling the property. If she had sold it, she would not have probably obtained this price, and she would have had to give 6% of that money to a realtor. By getting a lender to give her 100% of this money, she comes out at least $38,700 ahead, and probably more than that when you consider the discount to move the property. It is a wonder more people did not do this.
It appears as if she made two payments before stopping. I guess the intent to defraud is not quite so obvious if you make a token effort at payment? The notice of default was served in July for back payments of $19,943, and the property was purchased by the lender at auction on 1/11/2008 for $691.227. The additional $46,227 being lost payments and expenses.
Income Requirement: $143,725
Downpayment Needed: $114,980
Monthly Equity Burn: $4,790
Purchase Price: $529,000
Purchase Date: 9/23/2003
Address: 4 Moss Glen #13, Irvine, CA 92603
|View(s):||Park or Green Belt|
|On Redfin:||3 days|
Townhouse style condo, 2 attached garage with direct access to the unit. Fireplace in living room with sliding glass door to patio. Light & bright, vaulted ceilings & skylights. 2 balconies upstairs, with view of greenbelt. Spa tub in master bath.
This property is one of the few stressed properties I have seen in Turtle Rock. A healthy market would absorb a few of these without much damage, but in a stressed market like ours practically devoid of buyers, a few of these properties set the comps, and values take a serious dive. Our market is as fragile as an egg, and these foreclosures are as violent as a sledge hammer.
This property is the tale of two parties. The lady who “put” this property to the lender made $116,000 on the deal. She will have to deal with bad credit, and if she has any of this money in liquid assets, the lender may go after it, but in all likelihood, she will get to keep her “profits” from the foreclosure. The lender will not do quite so well on the deal. Their basis is $691.227 plus whatever expenses they incur managing the property through disposition. If they manage to get this selling price and pay a 6% commission, the lender stands to lose $150,821. Let that one sink in for a moment. This lender made a loan, received two payments, and then proceeded to lose $150,000.
The “put” and “call” option features of mortgages during the bubble are the direct result of 100% financing. Speculators and homeowners have too little to lose to behave responsibly when 100% financing is available. Without increasing the cost to speculators through downpayments or a loan-to-value limit on refinances, speculators are going to utilize these mortgage products in ways they were not intended. There were many expensive lessons learned by lenders concerning 100% financing during the Great Housing Bubble.
Wanna be’s throwin’ ones tryin’ to show that they makin cash
Lookin’ stupid than a mother all though it’ll raise ya tabs
Cause the vehicles and jewelry we got is way mo’ advanced
There’s more colors in a watch than a set of jamaican flags
Pick it all up in bags the promoters like make it fast
Cause here comes another monsoon and these boys is goin’ make it last
Y’all hit the club tryin’ to act like ya poppin’ tags
Hit the club and ya new clothes and you know you goin’ take it back
I’m a fly rides owner ain’t no need to take a cab
Cause the key ain’t nothin’ to me I got cars so just take the slab
Say you doin’ it bigger it trip us so they can laugh
Cause I done ran threw way mo’ numbers than student’s can do in math
40 large in my pocket’s is causin’ my pants to sag
Still in love with my money like I use to say in the past
Got a Lot of Options — Chamillionaire